HA

UNIT 5 : OPEN ECONOMY AND

MACROECONOMIC POLICY

SHIRSENDU ROYCHOWDHURY
ST.XAVIER’S COLLEGE (AUTONOMOUS), KOLKATA

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INTRODUCTION
If a country is engaged in transactions with any other foreign country, then the concerned country
is considered to be an open economy.
The degree of openness depends on the following:
• The share of import and export (share of foreign trade) as a proportion of total value of
GDP.
Greater the value => greater the degree of openness (Widely used measure)
• Value of import duties as proportion of total value of imports
Lesser the value => greater the degree of openness
THREE TYPES OF OPENNESS OF AN ECONOMY
• Goods market openness: Trade of goods and services across borders
(e.g. Trade of commodities)
• Capital market openness: Trade of financial assets across countries (only financial
capital not physical capital)
(e.g. Investors choosing between foreign and domestic assets, suppose foreigner
purchasing share of domestic company)
• Factor market openness: Movement of factors of production across national boundaries
(e.g. MNCs employing workers from different countries)

THE BALANCE OF PAYMENTS (BOP)

• The Balance of Payments (BoP) is a systematic record of all transactions between the
economic units of a country (households & firms) and the rest of the world.
• The BoP of a country is a comprehensive measure/statement of
 all the receipts of a country from rest of the world (RoW) and
 all the payments by the country to the rest of the world (RoW)
• The values are usually expressed
 either in terms of the domestic currency
 or in terms of Internationally/Universally accepted currency like dollars ($)

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CLASSIFICATION OF BOP
The BOP can be classified into :
• Current account (CA)
• Capital Account (KA)

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BALANCE IN CURRENT ACCOUNT (CAB)

CURRENT ACCOUNT => NO REPAYMENT OBLIGATIONS
 Note that, all items in the current account of the BoP have the characteristics that they do
not affect the assets and future liabilities of the citizens and institutions of the country or
it’s government.
 These are current receipts and payments without any implications in the future.
CAB = Total Receipt – Total Payments
= (Receipts from Visible and invisible exports + Unilateral Receipts)
– (Payments for visible and invisible imports + Unilateral Payments)
or, CAB = Balance of Trade + Net Unilateral Transfers
Or, CAB = Value of Exports – Value of Imports + Net Transfers from Abroad
= Net Exports + Net Transfers from Abroad
If CAB > 0
 the country has current account surplus => favourable balance in CA (net inflow of
foreign exchange i.e foreign exchange reserves will rise)
If CAB < 0
 the country has current account deficit => unfavourable balance in CA (net outflow of
foreign exchange i.e foreign exchange reserves will fall)
If CAB = 0
 the country’s current account is in balance
BALANCE OF TRADE (BOT) AND NET TRANSFER FROM ABROAD
• Net Export is nothing but trade balance (BoT)
• BoT> 0 => Trade Surplus
• BoT< 0 => Trade Deficit
• BoT> 0 => Balance of Trade is in balance
• If Net Transfer from Abroad > 0
• It implies that, foreign residents are transferring less out of India (e.g. Gifts,
Remittances) than Indians living in other countries are transferring from abroad.

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BALANCE IN CAPITAL ACCOUNT (KAB)

CAPITAL ACCOUNT => REPAYMENT OBLIGATIONS
 For Capital Account the transaction gives rise to future claims such as acquiring foreign
assets or shares in companies located abroad.
 Note: Capital account transactions yield interest income for domestic citizens and
shareholders from next period onwards and this constitute a part of current account
transactions
Capital Accounts Balance (KAB)
= Receipt form sale of assets to foreigners - spending on buying assets from foreigners.

CAPITAL RECEIPTS: COMPONENTS

 Foreign Investments
[1] Foreign Direct Investment (FDI): In this case, the investor has real control over
the assets. e.g. If a foreigner sets up a factory in India or buys an Indian firm or
purchases a significant percentage of shares of an Indian company it is considered as
FDI.
[2] Foreign Portfolio Investment (FPI): Here the investors do not purchase
significant share of an Indian company. e.g. If a foreigner buys less than 10% of the
shares of an Indian Company, it is treated as FPI

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 External Borrowing
[1] Commercial Borrowing: Domestic country may borrow from abroad for
commercial purposes like opening up a factory and the loans taken on the rate of
interest.
[2] As a form of Aid: Domestic company borrowing from abroad in a situation of
[3] In banks as Fixed Deposits: Some commercial banks in India are authorized by
RBI receive deposits in foreign currency. It can give fixed deposits in banks and this
will be considered as investment from foreigners.

 Recovery of External Loan:

If foreign country pays back the loans which they had taken earlier, flow of capital
increases in the given year.
CAPITAL PAYMENTS: COMPONENTS
 International Investment: Investment in foreign countries in terms of buying shares of
foreign companies or buying any foreign assets.
 External Lending: It can be of three types (similar to external barriers)
• Commercial Lending: Lending for commercial purpose
• As a form of Aid: Lending as a formal aid (to help)
• Capital payments by the banks: When the fixed deposits of the NRI becomes matured
for repayment and they are not renewed.

BALANCE OF PAYMENT (BOP) OF A COUNTRY

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CAN THERE BE ANY DISEQUILIBRIUM IN THE BALANCE OF PAYMENT (BOP) OF

A COUNTRY?
In order to understand this, we first need to know the difference between autonomous
transactions and accommodating transactions.
Autonomous Transactions:
Autonomous transactions refer to those international economic transactions that are
undertaken with the sole motive of earning profit.
These international transactions occur primarily due to market forces and economic decisions
made by private entities and governments without any direct influence or intervention from
monetary authorities. These transactions reflect the normal flow of goods, services, capital, and
financial assets between countries driven by factors such as consumer demand, investment
opportunities, trade agreements, and comparative advantages. Examples of autonomous
transactions include exports and imports of goods and services, foreign direct investment (FDI),
portfolio investment, and other transactions initiated by private individuals, firms, or
governments to pursue economic goals.
Accommodating Transactions:
Accommodating transactions refer to those international economic transactions that are
undertaken with the motive of correcting the disequilibrium in BOP due to autonomous
transactions.
Accommodating transactions, also known as official reserve transactions, are international
transactions conducted by central banks or monetary authorities to manage the balance of
payments and stabilize the exchange rate. These transactions are typically aimed at
accommodating imbalances in the BoP, ensuring stability in the foreign exchange market, and
maintaining adequate levels of official reserves. Accommodating transactions involve actions
such as buying or selling foreign currency reserves, providing foreign exchange liquidity, or
implementing monetary policies to influence exchange rates. Central banks may intervene in the
foreign exchange market to counteract excessive fluctuations in the exchange rate or to address
temporary mismatches between inflows and outflows of foreign currency.
Therefore , autonomous transactions represent the normal economic activities and
transactions between countries driven by market forces, while accommodating transactions
involve official interventions by central banks to manage the balance of payments and
stabilize the exchange rate.
• In the accounting sense, there cannot be any disequilibrium in the BoP.
• However in economic sense, there is no reason to believe there cannot be disequilibrium
in the BoP.
If receipts from the rest of the world (other than accommodating receipts) falls short of payments
to the RoW (other than accommodating payments), there will be BoP deficit

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i.e. If, receipts from RoW (except accommodating receipts) <payments to the RoW (except
accommodating payments) => There will be BoP deficit
If Payments to the rest of the world (other than accommodating payments ) falls short of receipts
from the RoW (other than accommodating receipts), there will be BoP Surplus
i.e. If, receipts from RoW (except accommodating receipts) > payments to the RoW (except
accommodating payments) =>There will be BoP Surplus
In economic sense, the BoP is in equilibrium only when,
autonomous payments to the RoW = autonomous receipts from RoW.
So, BoP in equilibrium when,
Total value of Receipts = Total value of payments
 Balance on CA and KA
Now, in case of BOP surplus, the accommodating BOP transactions ( accommodating capital
payments ) bring the BOP account to a balance. In case of BOP deficit, the accommodating BOP
transactions ( accommodating capital receipts ) bring the BOP account to a balance.
Note : Accommodating transactions are always capital account transactions and not current
account transactions.

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RELATION OF A COUTRY’S BOP SITUATION WITH MONEY SUPPLY

Suppose there is a BOP deficit. So, autonomous receipts are less than autonomous payments. So
there is a downward pressure on the foreign exchange reserves. Then the Central Bank might
decide to buy foreign exchange from domestic citizens & in return gives domestic currencies to
the citizens (Accommodating transaction). This will balance the BOP through accommodating
capital receipts (inflow of foreign currencies). As the domestic currency in the hands of the
public rises, the money supply of the economy will rise (through multiplier effect as the
monetary base of the economy rises through the rise of domestic currency).
Suppose there is a BOP surplus. So, autonomous receipts are more than autonomous payments.
So there is an increase in the foreign exchange reserves. Then the Central Bank might decide to
sell foreign exchange to domestic citizens & in return receive domestic currencies from the
citizens (Accommodating transaction). This will balance the BOP through accommodating
capital payments (outflow of foreign currencies). As the domestic currency in the hands of the
public decreases, the money supply of the economy will fall (through multiplier effect as the
monetary base of the economy falls through the decrease in the domestic currency).
BASIC ACCOUNTING RULE OF BOP
Any transaction leading to a net receipt of foreign exchange creates a surplus or credit in the
corresponding account.
Any transaction leading to a net payment of foreign exchange creates a deficit or debit in the
corresponding account
If, India’s Export > Import by India
 Net Export (NX) > 0 => Current Account Surplus
If, India’s Export <Import by India
 Net Export (NX) < 0 => Current Account Deficit
If Sales of Bonds to foreigners > Purchase of foreign bonds
 (borrowing from abroad) > (lending to foreigners)
 Surplus in Capital account (KA) [reason: acquiring foreign currency]
If Sales of Bonds to foreigners < Purchase of foreign bonds
 (borrowing from abroad) < (lending to foreigners)
 Deficit in Capital account (KA) [reason: foreign currency depletion]
Hence, Surplus in KA => Net Inflow and Deficit in KA => Net Outflow
When India borrows from abroad to fill up the gap between export and import, it’s current
account deficit is offset by capital account surplus.

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Repayment of foreign Loan => Deficit in Capital account

[Reason : it involves payment (outflow) of foreign exchange]
An increase in country’s foreign assets or a decrease in country’s foreign liability => Debit Entry
An increase in foreign asset is a purchase or import of assets.
We know ‘Imports’ in CA or KA carries a –ve (-) sign as it is associated with payments to
foreigners => Debit
A decrease in country’s foreign assets or an increase in country’s foreign liability => Credit Entry
A decrease in foreign asset is a sale or export of assets.
We know ‘Exports’ in CA or KA carries a +ve (+) sign as it is associated with receipts from
foreigners => Credit
AN IMPORTANT IDENTITY
Asset Trade has two components:
Trade among private Citizens (Private capital Account)
Purchase and Sale by Central Bank of the country (Official Reserve Transactions or ORT)
Given this we have,
Current account balance + Capital account balance + ORT = 0

What are official reserve transactions (ORT) of BOP ?

Official reserve transactions are transactions that are carried out by the country’s
monetary authority to modify the official reserves . A country’s official reserve is its gold
reserves, special drawing rights and marketable foreign currency. The official reserve
transactions are very important as they help to bring a balance in the country’s overall
balance of payments.

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EXCHANGE RATE
The exchange rate is usually defined as the number of units of domestic currency required to
purchase one unit of foreign currency. It is the rate at which foreign currency can be purchased in
terms of the domestic currency.

NOMINAL EXCHANGE RATE VERSUS REAL EXCHANGE RATE

Nominal Exchange Rate is the exchange rate of a currency against any other currency. i.e. the
price of foreign currency in nominal terms.
India’s nominal exchange rate with respect to USA is the amount of rupee that needs to be given
up/sacrificed to get one dollar ($)
Denote Home Price Level (P) & Foreign price Level P*
NER = RER (P/P*)
Real Exchange Rate is designed to measure the rate at which home goods exchange for foreign
goods rather than the rate at which currencies themselves can be traded
India’s real exchange rate is the quantity of domestic goods which needs to be sacrificed/given
up to get one unit of foreign goods.
Denote Home Price Level (P) & Foreign price Level P*
RER = NER (P*/P)
SPOT EXCHANGE RATE VERSUS FORWARD EXCHANGE RATE
A spot exchange rate between two currencies is the rate applicable for immediate delivery.
A spot exchange rate represents a contracted price for the purchase or sale of a commodity,
security, or currency for immediate delivery and payment on the spot date, which is normally one
or two business days after the trade date.
A forward exchange rate applies to agreements for an exchange of two currencies at an agreed
date in future. It is designed for protection against foreign exchange risk.
Depending on the security being traded, forward rates are calculated from the spot rate and are
adjusted for the cost of carry to determine the future interest rate that equates the total return of a
longer-term investment with a strategy of rolling over a shorter-term investment.

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DETERMINATION OF EXCGANGE RATE

DEMAND FOR FOREIGN EXCHANGE

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SUPPLY OF FOREIGN EXCHANGE

DETERMINATION OF EQUILIBRIUM FOREIGN EXCHANGE RATE

The demand for and supply of foreign exchange plotted in same diagram
(note: P and P* constant)

The demand and supply of foreign exchange equates with

each other at point E

At E, Capital inflow = capital outflow

At E, domestic market equilibrium in BoP is achieved.

If Demand of FE > Supply of FE => BoP Deficit

If Demand of FE < Supply of FE => BoP Surplus

Here e* optimum or equilibrium exchange rate and FE* is

optimum or equilibrium level of foreign exchange.

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EXCHANGE RATE SYSTEM

An exchange rate system refers to the mechanism or framework through which a country's
currency value is determined in relation to other currencies.
There are several types of exchange rate systems, each with its own characteristics and
implications:
1. Floating Exchange Rate System (Flexible Exchange Rate System):

• In this system, the value of a currency is determined by market forces such as supply and
demand.
• Central banks may intervene occasionally to stabilize extreme fluctuations, but overall,
the exchange rate is largely market-driven.
• Countries with floating exchange rates include the United States, Japan, and the United
Kingdom.

2. Fixed Exchange Rate System (Pegged Exchange Rate System):

• Under this system, the value of a country's currency is fixed or pegged to the value of
another currency or a basket of currencies.
• Central banks actively intervene in the foreign exchange market to maintain the pegged
rate.
• Examples include the Hong Kong dollar pegged to the US dollar, and the Chinese yuan's
managed peg to a basket of currencies.

3. Managed Float (Dirty Float):

• This is a hybrid system where the exchange rate is nominally allowed to float according
to market forces, but the central bank may intervene occasionally to influence the
currency's value.
• Central banks might set target exchange rates or intervene to stabilize exchange rate
fluctuations.
• Many countries, such as India and Brazil, operate under a managed float system.

4. Crawling Peg (Adjustable Peg):

• In this system, the exchange rate is pegged to another currency or a basket of currencies,
but the pegged rate is periodically adjusted.
• The adjustments are usually made to reflect changes in economic fundamentals such as
inflation or trade imbalances.
• Some countries in the past, like Argentina, have used crawling pegs.

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5. Currency Board Arrangement:

• A currency board system is a type of fixed exchange rate regime where a country's central
bank holds reserves in a foreign currency at a fixed exchange rate and is required to
maintain a fixed exchange rate with that currency.
• The central bank issues domestic currency only when it has the equivalent amount of
foreign currency reserves to back it up.
• Examples include the Bulgarian lev, which is pegged to the euro through a currency
board arrangement.
Each exchange rate system has its advantages and disadvantages, and the choice of system
depends on various factors including economic stability, trade objectives, and monetary
policy goals.

We will discuss fixed and flexible exchange rates with the help of diagrams.
FIXED EXCHANGE RATE SYSTEM

• When supply of foreign exchange curve shifts rightward from SFE 1 to SFE 2
• E1E2 => Excess supply of foreign exchange
• Here central bank buys this excess amount of foreign exchange to bring equilibrium back
to E1.
• Here the exchange rate is kept fixed at e* by the central bank.

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FLEXIBLE EXCHANGE RATE SYSTEM

• Suppose supply of foreign exchange curve shifts rightward from SFE 1 to SFE 2
• Excess supply of foreign exchange
• Exchange rate starts adjusting to get back to equilibrium
• Here central bank does not intervene
• Exchange rate falls from e1 to e2 and equilibrium shifts from E1 to E2
• When the value of ‘e’ falls in the flexible exchange rate system due to change in
market conditions, there is appreciation of currency.

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DIFFERENCE BETWEEN FIXED AND FLEXIBLE EXCHANGE RATE SYSTEM

DEPRECIATION, DEVALUATION, APPRECIATION AND REVALUATION

Let the exchange rate (e) be Rs.75/$. Suppose exchange rate (e) increases. Let us assume that it
increases from Rs.75/$ to Rs.90/$. Then it means that previously we could get 1$ by spending
Rs.75 but now we have to spend Rs.90 to buy one $. So, we have to spend more Rupees now to
buy 1$. So, the value of domestic currency have decreased from 1 rupee = (1/75)$ = 0.0133 $ to
1 rupee = (1/90)$ = 0.0111 $. Therefore if exchange rate “e” increases then the value of the
domestic currency falls and similarly if exchange rate “e” decreases then the value of domestic
currency rises.
Now,
Rise in exchange rate (e) => Fall in the value of domestic currency
Fall in exchange rate (e) => Rise in the value of domestic currency
• In flexible exchange rate system when “e” rises by interaction of demand and supply
forces in the foreign exchange market then it is known as “Depreciation” of domestic
currency.
• In flexible exchange rate system when “e” falls by interaction of demand and supply
forces in the foreign exchange market then it is known as “Appreciation” of domestic
currency.

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• In fixed exchange rate system when “e” is made to rise as a part of policy of the
Government or the monetary authority of the country then it is called “ Devaluation” of
domestic currency.
• In fixed exchange rate system when “e” is made to fall as a part of policy of the
Government or the monetary authority of the country then it is called “ Revaluation” of
domestic currency.

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QUESTION SET :
1. What are the three types of openness ?
2. Mention two measures of openness of a country.
3. What do you understand by the BOP of a country ?
4. Explain the different components of the balance of payment of a country.
5. What is the fundamental difference between current account and capital account
transactions ?
6. What are autonomous and accommodating transactions of BOP ?
7. What are official reserve transactions of BOP ?
8. “Balance of payment always balances”. Does it mean that there are no
disequilibrium in the BOP of a country ?
9. If there is disequilibrium in BOP, then how will domestic money supply be affected ?
10. For each of the following transactions state to which account (current/capital) in
India’s BoP it belongs and whether it is a surplus (credit) or Deficit (Debit) item.
(Hint answers are mentioned below)
1. Purchase of South Korean Camera by an Indian Citizen.
Ans. Import of goods (visible) => Deficit (Debit) in Current account
2. Purchase of share of Indian Company by a German Mutual Fund
Ans. Capital Inflow => Surplus (Credit) in capital Account
3. Govt. of India borrowing from US bank
Ans. Net Capital Inflow => Surplus(Credit) in capital account
4. Export of handmade cotton fabric from India to Australia
Ans. Export of goods => Credit (Surplus) in current account
5. An Indonesian tourist paying in cash for a stay in a hotel in Delhi
Ans. Export of services (Invisible) => Credit (Surplus) in current account
6. An Indian citizen purchases a house in Sao Paolo, Brazil
Ans. Spending on purchase of asset abroad from foreigners =Deficit (Debit) in
capital account
7. An US investor making a deposit in State Bank of India
Ans. Net Capital Inflow => Surplus (Credit) in Capital account
11. What is exchange rate ?
12. What is the difference between nominal exchange rate and real exchange rate ?
13. What is the difference between spot exchange rate and forward exchange rate ?
14. Why the demand curve for foreign exchange is negatively related to the exchange
rate and why the supply of foreign exchange is positively related to exchange rate ?
15. Explain the determination of the equilibrium exchange rate in a flexible exchange
rate system ?
16. What are different types of exchange rate system ? Explain them.
17. If the supply of foreign exchange rises. Explain the impact on the equilibrium
exchange rate and the equilibrium quantity of foreign exchange with the help of
proper diagrams in case of fixed exchange rate regime and in case of flexible
exchange rate regime.
18. Explain the difference between devaluation and depreciation.

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19. Explain the difference between revaluation and appreciation.

REFERENCES / SUGGESTED READS :

1) MACROECONOMICS by N.GREGORY MANKIW ; 6TH EDITION , WORTH
PUBLISHERS
2) PRINCIPLES OF MACROECONOMICS by SOUMYEN SIKDAR ; 2ND EDITION,
OUP
3) MACROECONOMIC POLICY ENVIRONMENT-AN ANALYTICAL GUIDE FOR
MANAGERS by SHYAMAL ROY ; 2ND EDITION, TMH

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